The Office Investment Gamble

Several office markets battered by the tech wreck that jolted Wall Street and led to a recession four years ago are still plagued by double-digit vacancies. And in some cases, rents are 50% below the peak of the last real estate boom. But that hasn't fazed investors, who are generally paying more for properties today than they were in 2001 when the buildings were filled with tenants.

But a large number of investors who are still plowing capital into the office sector in troubled tech markets — or “buying vacancy” as analysts term the act — anticipate rent and occupancy growth as the economy improves. They are encouraged by job-growth figures.

The primary office-using employers — professional and business services, information and financial activities — added 334,000 workers in the first six months of 2005, and almost double that amount between July 2004 and July 2005, according to Grubb & Ellis. Nationwide, office users absorbed 25 million sq. ft. of Class-A space during the first half of 2005, compared with 16 million sq. ft. in the first half of 2004.

“The bet today is that by the time we see an increase in interest rates or cap rates, we'll have seen vacancy decline to the range needed to see real positive rent growth,” says Stuart Shiff, co-CEO for San Francisco-based Divco West Properties, which owns some 5 million sq. ft. of office space. “Investors are anticipating that space is going to get absorbed, and I don't think it's such a bad bet.”

In fact, in late 2003 Divco West partnered with real estate investment advisor RREEF to acquire Market Center in San Francisco for about $104 per sq. ft. At the time, the two-building, 770,000 sq. ft. property was about 80% vacant; today it's 60% occupied, Shiff says. Now office properties in the neighborhood are selling for about $400 per sq. ft.

Why the persistent pessimism?

A closer look under the hood shows that in terms of real estate fundamentals, some tech markets are falling short of the national trend. Oakland's downtown office sector, for example, experienced negative absorption of 9,000 sq. ft. in the second quarter of 2005 compared with 77,000 sq. ft. of positive absorption for the same period a year ago, according to CB Richard Ellis.

On the economic front, sustained job growth is hardly a foregone conclusion despite the creation of 646,000 jobs in the office-using sectors from June 2004 to June 2005. Boston, for instance, could see significant corporate downsizings as a number of mergers rattle the city. Case in point: Cincinnati-based Procter & Gamble Co.'s $57 billion acquisition of Gillette Co., on track to close this fall, could result in 6,000 layoffs.

Undaunted, many office buyers continue to converge on these markets. But investors who pay high prices for office properties and then fail to realize occupancy and rent growth risk lower-than-expected returns and big losses. The building's value may not rise as much as anticipated when it's time to refinance or sell the structure, for example, or the property's operations may not generate enough cash to pay debt service.

Scott Jamieson, senior vice president of capital markets for Spaulding & Slye Colliers in Boston, suggests the heady acquisition climate is more a function of fund managers who need to put capital to work. “I don't know if there's a whole lot of attention being paid to the real estate fundamentals,” he says, referring to absorption, rents and other pertinent indicators of performance.

Nicholas Buss, senior vice president and group manager at PNC Real Estate Finance, says that office buyers believe it's time to move back into bruised markets. “Are investors buying vacancy, or are they buying solid buildings in weak markets and hoping to see the upside?” he says. “Certainly, most people feel that those markets have turned the corner.”

Fundamental disconnect

Bullish investors argue that the office sector is moving in the right direction, albeit slowly, after hitting bottom in 2003. The CBDs that suffered the largest rent declines since 2001 — San Jose, San Francisco, Oakland, Boston, Austin, and Seattle — generally have recorded an improvement in the office vacancy rate, but there are some exceptions.

The vacancy rate in Austin registered 23.7% in the second quarter of 2005, up from 21.9% a year earlier. However, San Francisco reported a dramatic improvement in fundamentals. Vacancy dropped to 12.6% from 17.7% over the same period, according to CB Richard Ellis.

Meanwhile, average rents in those six markets are still a far cry from 2001 rates, reports Global Real Analytics. Boston reported Class-A downtown average rent of $38.75 per sq. ft. in the second quarter this year, which was 28% shy of what landlords were charging in 2001, the best four-year rent performance among the cities. The worst performance was in San Jose, where the average rent of $27.48 per sq. ft. in the second quarter, was 52% below $57.01 per sq. ft. reached in 2001.

Despite the soft rents, Global Real Analyatics reports that capitalization rates in all six CBDs fell to an average of 6.8% from 8.95% between mid-2001 and mid-2005, offering undeniable proof that office prices are still rising. In downtowns that experienced the least office rent decline over that period, including San Diego, Las Vegas and Washington, D.C., cap rates fell less dramatically, to 7.5% from 8.4%.

The high prices have convinced some office owners to cash out of tech markets. In San Francisco, cap rates for Class-A office buildings in CBDs plummeted to 6% from 8.7% between mid-2001 and mid-2005 as the average sales price climbed to $394 per sq. ft. from $373.

The falling cap rates prompted Younan Properties of Woodland Hills, Calif., to sell 12 buildings in California over the last three years, including the 210,000 sq. ft. Hitachi America Center in South San Francisco for $25 million in 2003.

The company is now focused on other markets including office properties in Phoenix and Chicago. In August, the company acquired a 1.1 million sq. ft. Dallas portfolio from Chicago-based Equity Office Properties for more than $90 million.

“We've seen the cap rate compression, and it raises an eyebrow because there isn't any correlation between cap rates and fundamentals,” emphasizes Zaya Younan, chairman and CEO of Younan Properties. The situation is particularly alarming, he adds, because the falling cap rates in some markets are approaching the cost of debt — the ten-year Treasury yield has been hovering around 4.2% for the last six months. “If you go back in history,” he says, “that's when you see markets crashing and assets devaluing.”

Defying conventional wisdom

Even though in some markets it's cheaper to build than buy, investors keep gobbling up existing buildings. In San Francisco, where it costs about $450 a sq. ft. to build Class-A office space, New York-based Pacific Gold Equities is marketing the 1.8 million sq. ft. Bank of America building and is expected to get its asking price of some $700 per sq. ft. (Pacific Gold bought the edifice last year for $444 a sq. ft.)

In Boston, where replacement cost is about $300 per sq. ft., Atlanta-based Wells Real Estate Investment Trust paid $687 per sq. ft. for the 98,000 sq. ft. One Brattle Square in Cambridge early this year. Experts label such transactions as anomalies and argue the deals mirror a strategy occurring in healthier markets: Investors pay high prices and accept lower yields in return for well-located buildings filled with low-risk, long-term credit tenants. Most real estate officials in tech markets generally don't anticipate new office development happening anytime soon. (Chicago is another story. See page 118.)

Bay Area: About to boom?

Nowhere are investors displaying optimism with more exuberance than in San Francisco, where office buyers are typically underwriting acquisitions to reflect a doubling of rental rates over the next 10 years, according to George Eckard, senior director of capital markets in the San Francisco office of Cushman Wakefield. Are buyers justified?

Office users in San Francisco absorbed some 1.7 million sq. ft. in the first half of 2005 compared with about 2 million sq. ft. for all of 2004, according to CB Richard Ellis. Between 2000 and 2003, the market had 12 quarters of negative absorption of some 9 million sq. ft.

In addition to San Francisco's five-point drop in the vacancy rate to 12.6% between the second quarters of 2004 and 2005, the city was expected to add 4,600 office jobs by year's end, according to the San Francisco office of Newmark Pacific, a full-service real estate firm. Plus, converters are turning older office buildings into residences, further depleting overall inventory, Eckard adds.

Office experts also are encouraged by companies moving to the area. Case in point: Earlier this year, Gap Inc. announced plans to move its Old Navy team into an empty 280,000 sq. ft. building in Mission Bay next year, and some workers already have moved to San Francisco from New York.

In 2000, Gap had agreed to a 15-year lease at the property, which was built by San Francisco-based Catellus Development Corp in 2002. The retailer never moved in, though it has been making lease payments for the last three years and had earmarked a reserve of $58 million to cover the lease-related loss.

The recent announcement to occupy the building prompted Gap to essentially cancel the reserve. Catellus is marketing the property and is expected to get about $600 per sq. ft.

Yahoo! Inc. signed a letter of intent in August to lease 200,000 sq. ft. at 475 Sansome St. Yahoo's move also harkens to the 1990s, when companies located in CBDs to attract workers.

“The obvious intellectual capital at Stanford to the south and Cal-Berkley to the east, is a definite driver of the San Francisco market,” Eckard says, referring to Stanford University just outside Palo Alto, Calif., and the University of California, Berkley. “You have an incredible population of young people living in the city who don't want to live in bedroom communities.”

Coming soon: A landlord's market

Despite the hopeful signs, rents are essentially flat. Average asking rents for Class-A space in downtown San Francisco crept up to $31.08 per sq. ft. in the second quarter of 2005 from about $28 a sq. ft. in the second quarter of 2004, according to Global Real Analytics.

But those rents are nowhere close to the nearly $60 per sq. ft. that landlords were fetching in mid-2001, just before the bottom dropped out of the market. And it will be a while before rents return to that lofty amount: Cushman & Wakefield projects that downtown Class-A office space will go for nearly $59 per sq. ft. by 2014.

At Market Center, most leasing activity has occurred on the lower floors — or “commodity space” — for around $28 per sq. ft. Divco West and RREEF underwrote the acquisition at about $23 per sq. ft., says Shiff of Divco West.

But much like other San Francisco landlords, Divco West and RREEF are asking for approximately $38 per sq. ft. for Market Center's upper floors — the coveted “view space” that offers skyline and bay vistas. In fact, Shiff expects view space rents to break $40 per sq. ft. and approach $50 in the months ahead as vacancy in the market nears and then falls below 10%.

“In every cycle, when vacancy is between 15% and 20%, you see leverage in the hands of tenants,” he says. “But when vacancy goes below 10%, that's when you see a significant shift of leverage toward the landlord.

Joe Gose is a Kansas City-based writer.

Fundamentals be damned in Chicago

Double-digit office vacancy rates typically have a way of restraining even the boldest developers. But when tenants want new digs and capital flows freely, some developers just can't stop themselves. Such a situation is unfolding in Chicago these days, where an ill-timed office building boom will add some 5.3 million sq. ft. to the central business district over the next few years.

With less than half of that total space built, the direct vacancy rate in downtown office buildings was 15.5% in the second quarter, up from 14.1% during the same period a year ago, reports CB Richard Ellis. Meanwhile, rents have risen only slightly. Gross average asking rents nudged up to $26.95 per sq. ft. from $26.29 per sq. ft. over the same time period, reports Chicago-based Bradford Allen Realty Services.

The development may not stop anytime soon despite the weak fundamentals. Late this summer, Chicago developer John Buck contracted to sell his 1 million sq. ft. edifice at 111 S. Wacker Drive for a record $410 a sq. ft. to German investment fund DIFA Deutsche Immobilien Fonds AG. Buck completed the 51-story building for $280 million in June. The building is now 80% occupied.

Buck is making preliminary plans to develop a tower at 155 N. Wacker that could add more than 1 million sq. ft. of office space to the existing supply. “Purely from a demand standpoint, there's no true need for these buildings,” says Laurence Elbaum, principal of Bradford Allen.

Most tenants signing up for new buildings are vacating structures built 15 to 20 years ago, says Bruce Miller, managing director of capital markets for Jones Lang LaSalle. Many companies today want large floor plates in modern buildings. Deloitte & Touche was one such tenant when it agreed to anchor 111 S. Wacker in 2002.

Law firms began lining up for new space to keep up appearances after Mayer Brown Rowe & Maw agreed to anchor Hyatt Center at 71 S. Wacker in 2002. Chicago-based Higgins Development and the billionaire Pritzker family partnered to develop the 47-story tower completed this summer. “Law firms see their competition in new buildings. They believe they need to be in similar buildings from a recruiting and prestige perspective,” Miller says.

In early 2003, Sidley Brown & Wood committed to 1 S. Dearborn, an 820,000 sq. ft. Houston-based Hines project slated to open in the fourth quarter. Also in 2003, Lord Bissell & Brook and Grippo & Elden committed to 111 S. Wacker. In August this year, Kirkland Ellis announced it would anchor a 1.3 million sq. ft. Hines development at 300 N. LaSalle, which is scheduled to break ground in spring 2006.

Companies playing musical chairs are driving most of the activity. “Chicago will be a tenant's market for a long time,” Elbaum predicts. “It's difficult for the landlords, and it will get more difficult.”— Joe Gose